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Econ Focus

First Quarter 2018

Federal Reserve

A Taxing Question for the Fed

The Fed has long emphasized uncertainty in assessing the economic effects of tax cuts. Both history and theory might help explain why

Article by: Helen Fessenden

On Dec. 13, 2017, the Federal Open Market Committee, or FOMC, concluded its policy meeting by raising the fed funds rate for the fifth time since the Great Recession, citing a strengthening labor market and "solid" economic activity. The day was also the occasion of the final press conference of outgoing Fed Chair Janet Yellen, which immediately followed the meeting.

The initial round of questions from reporters, however, focused on fiscal policy — specifically, President Donald Trump's tax bill, which was about to clear Congress. (See "Policy Update" in this issue.) By cutting individual and corporate taxes by $1.5 trillion over 10 years, its backers argued, it would encourage greater investment, ultimately spurring productivity and boosting economic growth. Yet when asked how the legislation would affect the Fed's outlook on output, inflation, and monetary policy, Yellen struck an agnostic tone.

"Much uncertainty remains about the macroeconomic effects of the specific measures that ultimately may be implemented," she said, referencing the economic projections that the committee issues on a quarterly basis. "Changes in tax policy [are] only one of a number of factors, including incoming data that has, to some extent, altered the outlook for growth and inflation."

Other Fed officials issued similar caveats in the following months. The FOMC's January 2018 minutes, for example, noted that "several participants expressed considerable uncertainty about the degree to which changes to corporate taxes would support business investment and capacity expansion." And in his first press conference as Fed chairman, Jerome Powell said that while the bill had "elements that should encourage investment, which should help productivity [and] encourage labor force participation," the committee also didn't "know how big those effects are going to be."

This episode isn't an exception. For long-standing reasons, the Fed has generally been guarded in assessing the degree and timing of tax cut effects. Former Fed Chairman Ben Bernanke explained this approach in a blog post last year. For one, he wrote, the Fed tends to be a cautious institution in the face of uncertainty. In particular, the details of tax changes are often unclear until passage and sometimes well thereafter. The Fed also faces the daunting task of incorporating all relevant variables into its forecasts — including factors that might mitigate the impact of tax policy — while steering clear of making public statements on political matters.

As Bernanke also noted, however, the Fed's caution reflects what economists know about the likely effects of tax changes. Most tax cuts since 1981 have been temporary, phased in, later offset, or passed at times when any stimulus was facing economic headwinds — and theory suggests all these factors affect the magnitude and timing of the resulting stimulus.

The Long and Short of It

Economic theory holds that people seek to smooth out consumption over time based on their expectations of income and wealth for their entire lifetime — what economists call the "permanent income hypothesis." If you get a one-time bonus, for example, theory would imply that your boost in consumption today will be less than the full amount of the bonus because you'll want to save at least some of it for future consumption. On the other hand, if you have an increase in your salary and you believe it's permanent, you'll spend a larger share of the increase. The ideas behind the permanent income hypothesis are one reason why economists have long argued that if fiscal policymakers truly want to boost investment, consumption, and output, permanent tax cuts are far more effective than temporary ones.

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